What Good Is It, Anyway?

Behind the ephemeral debates over the financial crisis and the bailouts it has spawned, there is a broader debate about the financial sector as a whole: what good is it, how much of it do we need, and how do we know if it is working? 

There are many descriptions of what the financial sector does, but most of them have something to do with moving capital (money) from someone who has more than he needs to someone who could use a bit more. And I think most people would agree that is a good thing, as long as the latter person has some productive use for it. Mike at Rortybomb, in “The Financial Sector We Want,” describes a doctor saving up $1,000 more than she needs for consumption and lending it to a factory, which returns her $1,100 after a year. In real life, we need some kind of a financial sector to get the money from the doctor to the factory, even if it’s just a single local bank. Everyone is happy.

When you start asking how big the financial sector should be, and whether or not it is working properly, things get more complicated. One of the Economist’s Free Exchange bloggers took the position that financial innovation is generally good in and of itself, although it has a high risk of creating “negative spillovers” – a higher risk than for non-financial innovation: “Most financial innovations are positive, and we don’t know ex ante which will be negative, so giving ourselves the power to block certain innovations because they might have negative spillovers is risky.” At first blush, this seems like a reasonable extension from real-world innovation to financial innovation.

However, Mike (Rortybomb) has an interesting counter-argument. Financial innovation, he says, is not like real-world innovation; the former only creates value if it solves an existing market imperfection. Figuring out which factories are worth investing in – so the doctor doesn’t have to worry about it – solves a market imperfection. But his point is that it’s the factory that’s creating the value; the financial sector is helping make that possible. So, he argues, if someone figures out a way to get a higher yield out of a risk-free investment (and that was the point of the CDO boom, where you could create a “super-senior, better-than-AAA” bond that paid a higher yield than Treasuries), then you either have to show what market imperfection it is solving, or it isn’t actually risk-free. In most cases, he suspects, innovation that generates a higher return does so simply by taking on more risk.

So what are we to make of the last quarter-century, when the financial sector got bigger and bigger and the people in it got richer and richer?

An instinctive free-market reaction might be to assume that the financial sector was doing great things, and that the people getting rich deserved to. But from Mike’s perspective, you have to ask: did people suddenly discover how to fix such massive market imperfections that they deserved to make that much money for so long? Ryan Avent put it this way:

Frankly, I have no idea what most of the recent growth in finance was for. . . . To get back to Mike’s original point, when you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

And Felix Salmon, I think, pinpointed the crucial issue. If the financial sector was doing such a good job innovating, then it shouldn’t have continued making so much money. 

[O]ne would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft and Intel together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees; but for at least the last ten years, no one going there has gotten anything more than a decent salary and a good resume credential. As computers get smaller, cheaper, and faster, the benefits flow overwhelmingly to their customers – to us. And those are near-monopolies. The general pattern in the technology industry is that a few entrepreneurs make a lot of money, and the vast majority of people make a decent salary; even the highly-educated, highly-trained, hard-working software developers, most of whom could have been “financial” engineers, are making less than a banker one year out of business school.

That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation). Why this happened I won’t try to get into here, but it would be worth understanding if we want to reduce the chances of living through this crisis again in our lifetimes.

By James Kwak

53 thoughts on “What Good Is It, Anyway?

  1. You know, since the crisis – since the debate over bonuses – I keep thinking about my father-in-law – a radiologist – a man who partnered with other doctors to build up a thriving practice within his community. He and his partners went every year to the RSNA convention to check out new technology. If they liked what they saw, they invested in tools that enhanced their business – tools like ultrasounds and MRIs and things of that nature.

    They used this technology to help heal sick people. To diagnose illness. To show a pregnant woman the baby she carried within her.

    They made money working in this way. Not the kind of money you see on Wall Street – but good money, nonetheless.

    My father-in-law is now retired – and lately, a little shell-shocked. The portfolio he worked so hard to build up has been devastated by the gambling that has gone on within the financial community.

    The financial sector doesn’t invent. It doesn’t produce. Its work is to structure multi-million dollar deals between really big companies. (John Bogle has a lot to say on this aspect of their work in his book, “Enough” – let’s just say he’s not a fan.) From what we’ve seen lately, the financial community’s innovation is in developing instruments that obscure long-term risk for short-term gain.

    A small sector of the country – those within finance – have profited astronomically from the services provided by their firms. Despite the crash of their companies, they remain exceptionally well-paid.

    For the consumers of their services – a completely different story. It’s been a bust. A total and complete bust.

    Compensation is a key issue to be addressed, if we want to avoid seeing a crash like this again. Have you seen Jon Danielsson’s post on Vox about the impact bonuses had on the crash? You can find it here:

    http://www.voxeu.org/index.php?q=node/3602. Curious about your thoughts on his post…..

  2. Many market participants have been misusing the word “hedge” for years – they talk about hedging the risk associated with a position when they are really just transferring their risk from one type of risk to another.

    I think financial innovation, to the extent that it brings new investors into markets they would not have otherwise participated in, is generally a good thing for the market. But I have seen what you are saying about financial innovation in various aspects of the muni market. For example, the cost of issuing new debt decreased significantly over the past two decades as the industry grew and as technology improved. To generate fees, banks started aggressively marketing interest rate swaps to governments.

  3. James,
    i do not believe you can have this discussion without getting to the very heart of the matter, this being you cannot have an economic/financial process without a corresponding political process.
    Whilst since the 1960’s we have had an exponential growth in economists, sadly, this has been divorced from the study of economics and political science – the mess we are in today can be ascribed as a direct consequence of this.
    Whilst many often refer to Adam Smith, they ignore the political underpinnings of many of his expressed arguments, the same is true of many of the nineteenth century great economic tracts, and this includes much of the economics of Karl Marx – who’s works I note are being dusted off again and looked at seriously by commentators globally.
    I believe its fair to say that of course there will always exist a requirement for a solid financial services sector that benefits the many. When we bastardise this structure to the extent that only a small minority ever benefits, we then have to seriously question the structure and change it accordingly to benefit the many.
    An internal debate on this matter has existed in the USA since the founding of the nation in 1776 and the creation of its Federal Constitution in 1789. Much can be gleaned from the “Federalist Papers” themselves and discussion on a Central bank between Hamiltonians and Jackstonians. Such debate is as relevant today as it was in the founding years of the Republic and deserves greater attention on these boards.
    As a Brit, maybe I’m not best placed to undertake this dialogue, although your colleague, Prof. Johnson has no such qualms on this matter.
    i trust this informs the dialogue a little further and allows us to cast our nets wider than just concentrating on the financial crisis at this juncture in time.

  4. We constantly hear from defenders of financial innovation that exotic financial products must serve a need, or they wouldn’t be in demand.

    But what exactly is that need?

    I believe that the buyers of many of these products simply don’t understand them. Their sales are driven not by economic need, but by flaws in human nature. These are the same flaws that drive people to buy get-rich-quick videos at 3 am, or to buy things because everyone else is buying them, or to believe that they understand what they are doing when they don’t.

    Even if these products actually did increase the efficiency of capital allocation, many of them would still have a net negative effect due to their marginal benefits but much higher complexity and associated risk. However, it is entirely likely that many of them do absolutely nothing to steer capital to where it’s put to its best use. Therefore, their sole purpose is to make the sellers rich (because the buyers cannot value the product properly) and to make the buyers feel as though they are doing something.

    Furthermore, I think that the whole idea of needing financial products to allocate capital in a perfectly efficient way is ludicrous. In a perfectly free market, with rational and knowledgeable investors, it might make sense. But as we all know, these don’t exist. The flow of capital in markets is already influenced by any number of external factors, government being the most obvious. And when capital flow is influenced (for better or for worse) by the whims of human beings and politics, as opposed to an ideal and theoretical market, it may not matter if we are particularly precise in our allocation. We may be so far off in our accuracy that precision will be pointless.

  5. I’d be interested in what James and Simon think of Carlota Perez?


    I am not 100% convinced by her theory that capitalism is characterised by roughly 60-year surges driven by big bang technological innovations (1771 steam engine, 1829 railways, 1876 Bessemer steel process, 1908 Model T Ford, 1971 microprocessors) – but her analysis of the role of finance capital in technological revolutions is very suggestive.

    Perez claims such epoch-making technological innovations are almost never financed by existing big producers and to get off the ground require the support of finance capital.

    After an initial adoption phase the runaway success of the new technologies and the new markets they spawn then channels vast profits into the finance sector which initially supported them – initiating a lengthy frenzy phase which invariably ends in a massive slump.

    This in turn forces govt to set up new regulatory systems and redistributive mechanisms to repair some of the damage wrought by triumphant finance capital – and ushers in a golden age when producers are in firm control and finance is relegated to a supportive role.

    And then someone comes along and inevnts a new widget that starts the whole cycle again…

    It is easy to quibble with her timescales – although to be fair given that her surges are driven by technological innovations rather than business or trade ‘cycles’ (a term she deliberately rejects) they don’t actually need to be 40 or 50 or 60 or 70 years apart – but she does seem to rather neatly explain the current crisis.

  6. Wow, this isn’t even close to right. For one thing, the size of the financial sector relative to the US economy is completely irrelevant. Financial markets are global, and the US financial sector serves much more than just the US economy. Paul Krugman won his Nobel prize for explaining how comparative advantage interacts with regional agglomeration.

    Also, competition pushes prices down to marginal cost, and there’s nothing in economic theory that says marginal cost has to be low. Even after a financial product has been created, standardized, and exposed to intense competition, it’s not inefficiency for a financier who deals in that product to make a lot of money. If the marginal cost is high, then fees will be high. Financial sector pay has also risen in part just because the volume of financial transactions has grown so much as the world — and especially China and India — have become wealthier.

    I know this won’t be popular, but you also have to remember that people in finance work a lot harder than most Americans. In what other industry are 18 to 20-hour days standard fare? We sacrifice a lot more in terms of our personal lives, family time, and personal health than most people. Do you wake up at 4 a.m. and get home at midnight every day? I didn’t think so.

    Finally, if Kwak thinks the CDO boom was driven by the super-senior tranches, then he doesn’t know much about CDOs. The CDO boom was driven by (1) investors’ thirst for mezz tranches (The Great Reach for Yield), and (2) banks’ desire to reduce regulatory capital under Basel II.

    For as much as the blogosphere likes to congratulate itself for the depth and sophistication of its commentary, the discussion of the financial crisis in the blogosphere remains laughably superficial.

  7. The problem is that engineer’s salaries are considered only ‘decent’. MSFT & INTC also were making more money when there products were demonstrably better to consumers – Win95 better than 3.1, 2000 better than Win95, XP better than 2000, Vista… Intel’s clock speeds, which is most user’s measure of cpu quality have stopped their exponential rise. They are also hitting physical limits with shrinking.

    Venture capital does more to fund startups than Wall St. does, and they were less prone to excess. Dot-com’s exploded when they could IPO and cash in.

    When people were talking about the efficiency of markets, I could only think of dot-coms. Markets are only efficient when you look at long-term results. In retrospect, during the dot-com boom, capital was obviously allocated to projects it shouldn’t have been. For the housing/credit bubble the same is now seen.

    Part of what happened is that banks were booking fees & profits on 30 year instruments immediately. You could pick up 3+% on just setting up the loan, with no capital at risk. Subprime loans were preferred because of their lower refinance rate, which at the time was the loan risk, while default was virtually ignored. You had an environment of decreasing interest rates and increasing home prices, pushed many to either buy or refinance. That system will eventually hit its limits and become unstable.

    If firms were compensated as a percentage of the incoming revenue stream, and up front costs were minimal, they would have behaved differently. The firms would have to transform the semi-risky annuity into the salaries of their employees. It would have minimized the bombs planted with mortgages that no one ever expected to be paid for more than 2 years, with the serial refinance being the target. If you only book 2/30th the fee if a loan gets refinanced, you’ll avoid giving loans you know will need to be refi’d.

  8. Also needed is transparency. Not to take away from the good points you make, James, but a free market depends on free exchange of information. All of the ill-advised lending that went on, from the foolish mortgages to the sophisticated credit default swaps was concealed by such complexity and lack of openness that banks were afraid to even guess at each other’s exposure to losses.

    I’m not a believer in efficient or omniscient markets, but to the extent that free markets do work, they are absolutely dependent on openness and good information. Clearly both were and still are lacking. Investing and efficient allocation of capital is a farce without information and transparency.

  9. “Do you wake up at 4 a.m. and get home at midnight every day? I didn’t think so.”

    No, but I also don’t screw up the world economy, cause hundreds of millions to be unemployed, or bring the world’s major power to financial ruin.

    By the way there are plenty of people (though not me, as I said) who work these kind of hours but don’t get paid huge bucks – look at the people holding down two jobs.

    And I modestly propose that a fireman, a policeman, or a soldier, who put their lives on the line when they do their job, deserve much more than someone who just works a lot of hours, safe in a comfortable chair in an air-conditioned office.

    You don’t deserve your money; stop justifying it and get a life.

  10. How about this idea:

    An economic constitution.

    Just as we have a constitution to structure and put limit our government, why couldn’t we have a similar document to define and regulate the economy?

    Currently our economy is regulated by conflicting laws mostly structured to benefit special interests and conforming to no unifying national interest. Thus we have energy policy written by energy companies and so on.

    Underneath our economy is a cultural understand that we are a free market, but this understanding is so limited and undefined that even educated people believe that temporarily nationalizing the banks would make Obama a socialist.

    In fact, most elementary school children can distinguish between an ipod touch and a iphone, but they are going to graduate high school with a vague, if any, understanding of the difference between capitalism, socialism and communism.

    And yet it is economic forces that determine (at least for people living in developed countries) the quality of our lives and the life choices we have available to us.

    Confronted by a world that can be turned upside down by a relatively small number of bankers, shouldn’t we say, as our founding fathers did in the context of government, enough is enough?

    An economy like a government is created by the combined (and sometimes compelled) efforts of the whole population. Shouldn’t we define the basic structure for the economy, the rules for maintaining and modifying the structure, and the basic obligations, and protections for individuals?

    I don’t mean a planned economy. The outcome of a soccer game isn’t planned, but it takes place under an agreed upon set of rules. I don’t see an agreed upon set of rules operating in our economy. What i see instead is that individuals are vulnerable to economic caprice and injustice that temporarily benefits a small minority at the long term expense of the whole system.

  11. Right, the size of the financial industry relative to a country’s GDP is irrelevant—tell that to Iceland (maybe also Ireland, Great Britain and Austria).

    I’m glad you enjoy working 20 hour days, but you should be rewarded for the worth of your work. When the decisions you made while working 20 hour days blow up in your face, you shouldn’t come whining to the American taxpayers for welfare. And when you do come to us to fix the problems you made not only for your own industry but also for the whole country, you should expect that we will question the value of your work now that we have to pay for it.

  12. i could say many things but a couple stand out.

    — a lot of what the financial system did in 2003-2008 was open up the US market to foreign capital. the US has the largest and most homogeneous consumer market in the world, and so the rest of the world naturally wants to sell us stuff. in essence foreign countries loaned back a large amount of their profit to us to buy their stuff. that dynamic plumped up the size of the financial system.

    — the financial system will naturally be smaller going forward.

    — you are conflating two types of financial institution. there are banks and there are investor banks. people who work for banks generally make reasonably good money, certainly above average. people who work for investment banks generally make much more.

    — the comparison with the health care system does not make the health care system look too good. is 14% of gdp too big for the health care system? you tell me. how much of this is spent on accounting and resource allocation? on the insurance infrastructure? that is a financial system. how do hospitals finance large technology purchases? how often do people put themselves at risk by signing up for therapies that they don’t completely understand? how much diagnostic testing is purely to drive profit margins of the bookkeepers? how much intervention is the same? how do drug marketers justify their jobs? i could go on. complex issues, all overlapping with the financial system. no, i don’t have any answers.

  13. Robby’s economic constitution rather reminds me of Chesterton’s definition of conservatism as ‘the democracy of the dead’.

    Barring massive advances in gerontology in two, three or four generations all of us who voted for such a constitution would be dead – but our descendents would still be bound by it.

    But who is to say that our national interest – or indeed my, yours or any other nation state – will still be the same in 2109 as it is now.

    An economic constitution imposed in 1909 would undoubtedly have favoured not the new productive forces about to be unleashed by Ford’s production lines but firstly the captains of already established heavy industries and secondly the petit bourgeois with their little farms and workshops.

    Now as a fan of the Populist and Guild Socialist traditions I could idly speculate that a world governed by a an economic constitution passed by say a triumvirate of William Jennings Bryan, Andrew Carnegie and Eugene Victor Debs in 1909 might have turned out better (or at least more equal) than the one we live in now – but it would almost certainly have been a materially poorer and technologically less advanced one.

  14. true.

    i don’t know for sure, but i can imagine that when the television was invented and marketed en masse there were plenty of people who would have rejected economic growth through selling each other picture tubes.

  15. Q – on healthcare costs Canada, Japan, Australia, NZ, the UK and most of Western Europe all contrive to deliver roughly similar or better health outcomes to all their citizens for between 7% and 11% of GDP.


    Ergo the cost of all those ‘unnecessary’ US health expenditures you list is between 4% and 7% of its GDP.

    Now one could argue that in effect part of this additional expenditure is an invisible and unintended subsidy to other nations health care systems – in that paying for all of those unnecessary tests and treatments let the pharmaceutical companies invest in research that ultimately benefits everyone – however clearly that is just a fraction of 4 to 7% of GDP involved.

    Though as a Brit my knowledge is based on study rather than personal experience, I do find it difficult to believe that the US could spend much less than 15% of GDP on healthcare even if they magically had a more efficient single-payer system.

    The expectations of both consumers and producers of healthcare are very different and US patients would no mopre give up their batteries of tests or right to keep their brain-dead relatives on life support until the supreme court pulled the plug than doctors would give up their ocean-going yachts, BMWs and all that other expensive hi-tech equipment that they need.

    Mark – if you and your colleagues hadn’t been such dedicated Stakhanovites and had only put in say a nine-hour day and as a result developed rather fewer complex financial instruments then maybe the world economy might be in slightly better shape.

    However of course then the rest of us would be marginally richer (with that margin being for many the difference between destitution and a tolerable existence) and you’d all be a lot poorer (in purely relatively terms – i.e. still rich beyond most people on the planet’s wildest dreams) – so that would never do.

  16. I think you misinterpret my idea. I am not an economist, but it is apparent to anyone with a little perspective that the economy is the dominate force in most people’s lives and that this force is regulated in a very haphazard and capricious fashion. What I am proposing is that some order and unifying vision be placed on the economy.

    A unifying vision is a scary thought, but i mean it in a very general way. We have a unifying vision for our country as a place that values the individual, does not require any particular religious affiliation, and promotes this vision through a democratically elected government. These ideas, democracy, religious freedom, individual rights are neither instinctive nor very common in history, but we started with that vision and created a system to encourage it—a broad, flexible, modifiable system, i should add.

    Our culture and this system of government are very compatible with a capitalist economy. But it seems to me that we haven’t defined and structured what we mean by a capitalistic economy to the extent that we should. Clearly, when the founders of this country conceived our government they couldn’t not have imagined the extent of technological and economic change that would happen. They lived in a largely agrarian economy.

    Even Adam Smith acknowledged that the sort of pure capitalism he envisioned needed some regulation. Certainly after the recent financial meltdown, most people understand that regulation is necessary or we will be subject to a perpetual boom and bust cycle. But if we are going to have regulations, what are the first principles? Currently it seems to me that there is no coherence in the way we regulate economic activity.

    Reread your last paragraph. You say that an economy structured by Brian, Carnegie and Debs might have turned out better but that it would be materially poorer. My point is that we haven’t chosen what type of economy we want, instead we have simply let it happen to us. Of course, this is a gross simplification. There have been many choices, some quite enlightened (Bretton Woods, perhaps) and others, many others, for the benefit of narrow special interests. Our economy functions on the basis of a dim cultural (mis)conception of free markets and lots of special interest legislation much of it in blatant contradiction to our broad national interest.

  17. The financial sector is predicated upon debt with compound interest. This requires exponential growth in the economy to repay the debt with interest. Exponential growth at 2% real interest is not sustainable for more than a few hundred years. Exponential growth in a finite world cannot continue. Thus a debt/interest-based financial sector requires periodic resets (recessions, depressions, or dark ages) to continue in operation. Are we willing to tolerate the pain of these resets because we like the results in the interim? That would seem to be the trade-off. One cannot have one without the other. Avoiding the resets requires a new, successful economics, which as far as I know, no one has ever invented.

  18. Follwoing that analogy the Hollywood Studios felt exactly that way about TV and could point to the countless jobs destroyed through the closure of cinemas – as well as the public spaces and social interactions lost.

    However if we’d adopted my counterfactual Bryan-Carnegie-Debs economic constitution in 1909 then we’d have never had the cinemas in the first place as the owners and employees of theatres, music halls, circuses, chautauquas and the like would have effectively mobilised against them.

    Again I am enough of reactionary to wonder if that might have been such a bad thing…

  19. totally tangential, but from my point of view the ‘advances’ in communications and entertainment technology represent a very large improvement in quality of life.

    this depression will be better than the great depression simply because we can listen to whatever music we want whenever we want and we have seventy years of recorded music history to choose from.

    that is, as long as we can keep ourselves fed, clothed, and housed.

  20. As a socialist – I agree with a lot of what you say.

    Where I disagree is that an economic constitution is a practical solution under a capitalist or even market-socialist (assuming such a thing is possible) system.

    Now I think one of the reasons for our disagreement this is that as a European I am used to living in a political system where the state can and does intervene and set clear limits on the operations of markets (although far less effectively in recent decades than it ought to have) as part of day-to-day politics.

    As the US is blessed and cursed with a largely immutable political system designed to serve the interests of the farmers, slavers, merchants and artisans of the 13 colonies in 1787, clearly you think an equivalent constitutional settlement is required to somehow ring-fence away an economy that better serves the national from the interference of special interests.

    However I would argue that it is precisely the fact that we have looser and less logically consistent political constitutions that has allowed democracies outside of the US to constantly intervene in their economies – and through the interplay of rival special interests that represent workers and consumers as well as corporations to humanise and indeed socialise them.

    Our failure in more recent years to keep this up has been largely due to the erosion of national sovereignty through globalisation driven by largely US-based corporations.

    And it is this globalisation that would make your economic constitution unworkable – America’s economy is already being kept afloat primarily by the combination of Asian investment and loans with the cheap imports produced by those same countries.

    Nothing short of autarkic ‘constitutionally-circumscribed capitalism in one country’ or a genuine new world order able to impose its will on the entire planet would make your solution workable.

    Really all you need is a much stronger federal govt and a new New Deal paid for by redistribution taxation (i.e. what we were lucky enough to have in Europe before we adopted US neo-liberalism) – an economic constitution would actually be counter-productive.

  21. As a socialist I agree with a lot of what you say.

    Where I disagree is that an economic constitution is a practical solution under a capitalist or even market-socialist (assuming such a thing is possible) system.

    Now I think one of the reasons for our disagreement this is that as a European I am used to living in a political system where the state can and does intervene and set clear limits on the operations of markets (although far less effectively in recent decades than it ought to have) as part of day-to-day politics.

    As the US is blessed and cursed with a largely immutable political system designed to serve the interests of the farmers, slavers, merchants and artisans of the 13 colonies in 1787, clearly you think an equivalent constitutional settlement is required to somehow ring-fence away an economy that better serves the national from the interference of special interests.

    However I would argue that it is precisely the fact that we have looser and less logically consistent political constitutions that has allowed democracies outside of the US to constantly intervene in their economies – and through the interplay of rival special interests that represent workers and consumers as well as corporations to humanise and indeed socialise them.

    Our failure in more recent years to keep this up has been largely due to the erosion of national sovereignty through globalisation driven by largely US-based corporations.

    And it is this globalisation that would make your economic constitution unworkable – America’s economy is already being kept afloat primarily by the combination of Asian investment and loans with the cheap imports produced by those same countries.

    Nothing short of autarkic ‘constitutionally-circumscribed capitalism in one country’ or a genuine new world order able to impose its will on the entire planet would make your solution workable.

    Really all you need is a much stronger federal govt and a new New Deal paid for by redistribution taxation (i.e. what we were lucky enough to have in Europe before we adopted US neo-liberalism) – an economic constitution would actually be counter-productive.

  22. Politically mightn’t the very availability of such solitary diversions as music and TV and DVD films – and of course the internet – make the depression worse rather than better?

    With nothing else to fill his day an unemployed man in the 1930s might go on hunger marches, riot, picket, support radical parties and generally create enough disorder that govts would be forced to take action.

    Somehow I don’t think blogging or twittering will have the same effect.

  23. James, are you perhaps suggesting that something akin to Baumol’s Law should obtain in the realm of financial innovations? If so, isn’t there grounds for caution in applying technological, i.e., innovation assumptions to finance? Sure, there is a bright future for structured finance. However, what passed for innovation was frequently a mirage. Innovation was driven by a focus on optimization. Consequently, the financial system became more complex, fragile, and unstable.

    As with the ponzi schemes, what was old was seen as new again, driven by the social psychology of wishful thinking. One question which may be more philosophical than practical: Are financial innovations fundamentally different in nature from technological innovations? Are they more prone to failures based on information cascades?

  24. Arguably finance predicated on compound interest is as old as civilisation itself – see the archive of Assyrian business memoranda, invoices and receipts from 2,000 BC unearthed in Anatolia, the Hammurabic Law code or the frequent denunciations of usury in the Old Testament.

    So financial markets have been going strong for at least 4,000 years rather than a few hundred.

    As for the ‘new, succesful economics’ you are after Malthus – who pretty much invented exponential growth as a concept applicable to social phenomena – had a pretty good stab at it 200-odd years ago.

    His conclusion was that we (or God or fate) just need to engineer a good mass die-off every few decades so whatever it is that is ‘finite’ about our world can recover from our demands on it.

    Some of Malthus’s 20th century disciples – who in the case of Hitler and Mussolini shared your concerns about the long-term unsustainability of finance capitalism – got quite adept at implementing this before we decadent western liberals stopped them.

    However barring a few of the more honest Deep Greens overt Malthusianism doesn’t get much support these days.

  25. Perhaps an economic constitution is the wrong way to frame my suggestion. My point is that a government limited and structured by a constitutional framework was, i think, a huge advancement, and i don’t see, generally speaking, why the same can’t apply to an economy.

    It is always difficult to compare one system to another in a very dynamic world. I grant you that European governments have generally done a much better job at improving the welfare and health of their citizens. On the other hand, a awful lot of dotcom entrepreneurs came to this country from Europe because they found the regulatory environment stifling. Its hard to make an apples to apples comparison.

    I agree with you that a loose system is better able to adapt, but there has to be a system in the first place. I can’t say that we have a very clear economic system. A lot of this blog has been devoted to the hazards of socializing risk and privatizing profits. What kind of a system is this? In truth it is just a system of competing forces with no first principles.

    In fact, we have a perversion of socialized medicine. The sign in my local hospital says that you will be treated even if you don’t have insurance. The hospital and the insured citizens pay for this and it creates horrible inefficiencies and mis-incentives. What kind of a system is this? It is a system that does the obvious and necessary, providing health care to everybody (more or less) without acknowledging that healthcare is a basic right and an obligation for an economy to provide, one that should be of higher priority than million dollar bonuses.

    I admit to not having the time to think this idea through, but it seems that a lot of the economic structure we take for granted, central bank, unemployment insurance, bankruptcy laws, the SEC, minimum wage and hour laws, and no doubt the regulations that flow from this crisis, are the result of reactions to disasters rather than a logical attempt to create the kind of economy we want.

    No, i don’t want to create a document to regulate TVs or perpetuate buggy whip manufacturers, but is it too much to think that we could devise a basic framework? Think for instance of the decision to abandon what was left of the gold standard in the early seventies to make financing the Vietnam War easier. This decision, it seems to me, had long lasting consequences for the financial industry and domestic manufacturing, but it was made for political reasons. Wouldn’t it be better if we had an economic constitution and a system for examining that sort of choice against an agreed upon set of principles? Understand, I’m not saying whether or not that was a good choice. I don’t understand economics well enough. What i understand is that the way it was made had very little to do with the long term and probably predictable results.

    Or again, probably there shouldn’t be a law limiting investment bank leverage in perpetuity, but there should be a framework for setting the limit, a framework more structured on first principles than the current one in which some well-connected banks lobby their favorite congressman.

    Or think about the environment which is a massive piece of the economy. Shouldn’t there be a coherent way of assessing the environmental costs of certain activities? Sure this is achieved now by a competition between environmental lobbies and industrial lobbies. Does that really make sense? How do we square the need for resources with a finite environment and a ‘free market’? The existing political/legislative process doesn’t address this.

    In George Soros Alchemy of Finance he mentions that he always had a theory for where the markets were going, but also that he was willing to change his theory as events changed. I guess i am proposing a similar world view.

  26. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades —

    Depends on how you define “improvement”. When I got my first mortgage in 1986, it took 6 weeks and about 3 dozen phone calls. When I got my second one in 1999, it took 6 days and half dozen e-mails. Granted, my credit history became fully developed and documented in the interim, but there is no doubt the process of creating credit was streamlined (mortgage brokers would say it was perfected) over this time period. Because we collectively assumed the value of the collateral would never go down, we forgot to build in a couple of key features in the system. One: clawbacks for each player along the chain if the credit goes bad, and two: systems for reverse engineering bad mortgages.

  27. Opps, didn’t mean to include that last paragraph, guess now i will have to explain it. I think one of the brilliant aspects of the way Geogre Soros understands markets, is the way he insists on having a theory for what was going to happen in the market (read his real time experiment in the Alchemy of Finance) but is always willing to adapt the theory. However, underneath he sticks to his first principle, that markets do not seek equilibrium and that markets can create their own reality through a process he calls reflexivity. So, there is a very general theory for how the world works, reflexivity in Soros’ case, around which more ephemeral theories rise and fall. We have the ephemeral economic laws driven by special interests, but no underlying theory to return to. Consequently the economy runs us, has almost unlimited power over our lives even though it is a creation of our combined efforts.

  28. the symbol of this great financial recession will not be the downtrodden lining up for bread in the freezing cold (most people’s standard depression image) but the COUCH POTATO.

  29. Lots of criminals work hard. Lots of gamblers work hard.

    But it is not honest work, and neither is what you do. Consider turning your talents to something productive instead of being a leech on society.

  30. But what we saw was not financial innovation, it was transfer of wealth to a particular group that somehow managed to get a toehold of power. That is a large part of the economic history of the U.S.

  31. For some reason, i expected to see comments here on the question of what kind of banking sector do we want.

    Well, for starters:

    I want one that separates consumer lending (credit cards, mortgages, car loans) from wholesale trading. I would put small and mid-sized business and real estate lending under the consumer lending umbrella. I would put all corporate lending under trading. Anything big enough to consider a swap, as such, goes into the trading institution.

    Some people are talking in an interesting way about the difference between utility banking (deposits, payment settlements and loans) and trading.

    You would expect to be able to talk to somebody capable of making a decision at your bank. Lending decisions would be more than a matter of credit scores. You would be able to get credit outside the banking system, probably at a lower cost for a good risk or at a higher cost for bad risk. If you went for low cost outside the banking system, you would expect to be treated as a statistical cipher.

    Loans from banks would not be able to be securitized until they had been seasoned for at least one year and the originator would retain the servicing and the last out tranche. On this basis, they would really qualify for AAA.

    Although deposits would continue to be insured by the FDIC, a rating system would enable depositors to evaluate the relative safety of each institution. This could potentially put a market mechanism behind enforcement of regulatory compliance.

    The trading functions would not be regulated (in recognition of the fact that it is impossible to regulate this activity) nor would there be any government safety net for such activities.

    No attempt to reinstate the Glass-Steagall separation. Financial services conglomerates might include banks in the sense defined along with trading operations, so long as the banks were insulated from trading.

    There would be a revival of co-operative community banks, fostered by the government and the Federal Reserve which would serve the needs of most of the population and a movement away from consolidation of banking in ever greater institutions.

  32. Mark – aside from patting yourselves on the back for your incredible work ethic, what do people like you do from 4 a.m. to midnight?

    Seriously – can you outline the kind of work that takes up that kind of time? This is information I do not have, nor do I understand, and I would really appreciate getting an overview of “a day in the life” of an investment banker.

    Do you understand that if the financial community hadn’t clogged up the books/economy with an astonishing level of toxic assets, we wouldn’t be having this conversation today?

    Do you understand that the federal bailout of Wall Street gives the appearance of socializing the losses of some of the most profitable capitalists in the world?

    For many outside of Wall Street, the arduous labor of investment bankers seems to have done nothing but suck money out of the economy and into the pockets of the bankers. Can you discuss why that notion is a fallacy?

    Instead of insulting the “laughably superficial” discussion you find in the blogosphere, you might want to consider contributing some vital information to help people outside of the financial community understand the issues better.

  33. James, good post – although I wonder if it’s a bit US-centric.

    Pete Muldoon’s comment states it succinctly: what exactly is the need that exotic financial products fill?

    One need I can think of is very non-linear – people need to believe in growth in order to create growth. Many of the buyers of these complex products were non-US investors, and many of them were from emerging markets.

    What are emerging markets? They are places of very high investment risk, where the perceived risk of investing in a US-based CDO may be significantly less than investing in local firms or infrastructure.

    Is it possible that the global need addressed by complex securitization schemes has been in developing the confidence of emerging market investors in the idea of growth?

    In this view, the crisis may be a good thing: it may develop our confidence in the fact that the emerging world has not completely collapsed, and for those in the emerging world who have doubted their own abilities, the realization that the world’s financial leaders in the US and UK are human beings subject to the same mistakes as everyone else may prove to be the crack in the cosmic egg from which new ideas and growth can spring…

  34. Financial markets have not been strong for 4,000 years; there have been periodic resets. As I said, it has required recessions, depressions, world wars (forgot that one), and dark ages to tame compound growth over the last 4,000 years. The question is whether we’re willing to tolerate that antidote in return for the good times in between. Suggesting a periodic die-off is just another way of saying the same thing as dark ages and world wars. Sorry, I don’t find that very appealing.

    I think the situation is probably worse than it was 2,000 years ago; there was more room for growth then than there is now.

  35. Roger Sir,
    Thank you for reminding me about some of the work of Malthus again, I only wish I had both a copy of the “Wealth of Nations” and “Essays on the Principle of Population” at hand. Alas, all my political-economy books are languishing in the UK – this includes copies of Das Kapital and Mein Kampf
    However, as with many Brit’s one is very much a pessimist and prone to dystopian interludes.
    Personally, I do not believe we should evoke great names, and then give examples of how their thought has been utilised out of all context, indeed, the same can be said of Adam Smith’s views as expressed in his great work.
    Like you, one is of a left persuasion, however, I do not treat the work of Malthus lightly. Indeed, I fervently believe we are at an unsustainable level of population, and that this mixed with the utter greed exhibited under a capitalist framework, is a dangerous chemical mix and one prone to have horrendous consequences.
    In tangent with many others, it seems essential that we sooner or later aim for a population of no more than 5 billion and that our global wealth needs to be redistributed fairly among all inhabitants of our planet.
    Anti Malthusians have always pointed to the fact that agricultural production has been able to keep pace with population growth – unfortunately most of these gains have been via the use of petrochemicals and mechanisation reliant on the black stuff, which by all estimates will run out before the end of the century.
    One hates also to mention global warming and a crisis in drinking water that is again just around the corner.
    Hence I believe you can be both a green, Malthusian and good left winger all at the same time.
    Whilst i understand that it was science that actually gave birth to the ‘Holocaust’, I still believe it will be our salvation, certainly not under the current socio-economic arrangement though.
    one is also a little averse to both Huxley’s ‘Brave New World” and HG Well’s “The Shape of Things to Come.”
    Given an internationalist outlook, one tempered with contempt for many aspects of globalisation, I certainly hope one is not considered a fascist on these boards, niether, must it be said, am I a Communist, although much useful work can be gleaned from most of Marx’s economic tracts, and this means much, much more than just an acquaintance with Das Kapital.

  36. I fail to see the mystery here. The financial sector has been drawing huge rents off of the real productive economy, in effect, looting it. And much “financial innovation” has been directed at providing the means of obfuscation to effect that rent-extraction. (As a definition, economic rents would be profits displaced and detached from underlying costs-of-production, rather than profits in excess of those accruing to “perfect” competition, since the latter is a counter-factual largely not in evidence. In fact, competition largely aims at securing asymmetric advantages, i.e. blocking off the competitive diminishment of returns). But then the whole notion of “financial efficiency” is itself largely an obfuscation, based on a fallacious analogy between goods markets, based on underlying costs-of-production, (wherein rents may be partly “justified” as subsidizing high long-run fixed capital costs necessary to the technical productivity gained through large-scale production), and the packaging of credit “costs” into financial assets, whose “value” is determined by the apparent flow/extraction of corporate profits. But in fact, the overwhelmingly primary source of economic growth, increases in the real distributable surplus product, lies in technical improvements in the sphere of production, which raise productivity and lower output prices, which markets of various sorts might variously stimulate and promulgate, but do not of themselves produce, and financial intermediation only plays a limited role in determining and efficiently allocating between such prospects. The over-financialization of the real productive economy, generating bubbles in essentially fictive financial asset “values”, is effectively a symptom of blockages in real investment prospects and a damaging distortion on allocations of productive investment, not least because it distorts the distribution of income upwardly and undermines the level of real effective aggregate demand, which crucially influences the level of profits from real productive investment. Volcker was on the right track when he said the most significant financial innovation in the last generation was the ATM. Much of the other “innovations” amount to little more than pouring old wine into new bottles, a sophistication of goods, in the older sense of the word. But then if one sticks with standard academic neo-classical economics, with it’s fallacious account of price formation through the equation of marginal costs and marginal revenues, and equally fallacious account of distribution through largely fictitious marginal returns to factors, under “perfect” competition,- (and note that if firms are at all profit-seeking, their own-demand output curves will equate marginal costs with marginal profits, not revenues, and, insofar as fixed capital costs are a prevailing factor, most of that own-demand output curve will exhibit increasing rather than diminishing returns),- and its failure to adequately distinguish production from market-exchange,- (in fact, attempting to collapse the former into the latter through mathematic fudging devices),- and to distinguish between goods and financial asset markets, as if it were all reducible to undifferentiated flows of money, then none of the above will be at all apparent. If one wants to understand the sources of the current crisis/debacle, then what would be needed is a good theory of organizational and institutionalized rent-seeking/-extraction,- and on a global scale,- rather than one based on a “competitive” justification of profits.

  37. Tapeworms work 24/7, dude.
    And they “deserve” everything they can suck out of an organism.
    The only difference between you and them is they don’t invent a story to tell themselves that they aren’t tapeworms.
    Oh yeah .. they don’t log on to the Internet at 6:13am to justify their existence.

  38. Roger: “Somehow I don’t think blogging or twittering will have the same effect.”

    I’ve recommended this blog posting to two others, in two other states.

    I think that blogging and twittering have a huge potential to “create enough disorder that govts would be forced to take action.”

    Reading articles like this, and the (mostly) interesting and thoughtful comments, certainly helps to shape my thoughts and understanding.

  39. I like this idea! I fully agree that one of the greatest problems we face as a society is the “assumption of capitalism”. As you point out, most of the country doesn’t even know what that means, beyond being a nice slogan to lecture our friends and enemies with. Because it is so poorly defined, we have few common terms for our conversations on this vital topic. My capitalism may look completely different than my neighbor’s. Defining our terms would go a long way to move the conversations of our economy and by extension our politics forward.

  40. Good write up James.

    Perhaps this is simplifying the problem too much, but couldn’t the growth of the Western financial centres as a percent of Western GDP be attributed to massive amounts of capital (savings) flowing in from non-Western geographies? The Western financial system more or less manages the entire world’s capital. Thus as Asia began to invest its excess capital, sure this would push up the size of the WFS in proportion to Western GDP.

    But like I said, perhaps this is too simple. The scientist in me tries to find the simple solution before resorting to the political and way-over-dramatized theories that clog up most of these comment boards.

  41. > couldn’t the growth of the Western financial centres as a percent of Western GDP be attributed to massive amounts of capital (savings) flowing in from non-Western geographies?

    this is absolutely the case. a lot of the size of the financial sector, in the US and UK especially, is due to mediating the flow of asian savings toward investment in the US.

  42. How exactly does that argument work? China, for example, mainly buys Treasuries and agency bonds. I know that they are buying them via U.S. investment banks, not directly from Treasury and the agencies. But still, this is as low-margin a business as exists.

    I don’t buy this idea that volume alone should create large financial-sector profits, and especially not large per-banker compensation.

  43. The volume of capital recycling is not limited to U.S. Federal financing alone, but all forms of corporate, sovereign-wealth and municipal funding as well, both domestic and foreign. How many people in the U.S. have the financial skill set, social and business connections, and access to communications and technology tools to facilitate these transactions? I would guess it is not more than 10K or so. Layer the unfettered growth of leverage via the securitization markets (shadow banking system) on top of this, and you have a formula for very large income and disparities.

  44. I didn’t mean to infer that volume alone is the cause. Rather, I think that globalization, in general, had a lot to do with the growth of the WFCs. The growth in Asia has to financed somehow, and their regional financial centres lacked the capacity and expertise to handle the such an expansion. Just think about how many US and Euro banks set up offices in Asia over the past two decades. Then think about how large the Asian business is in most Western banks. I think I read recently that Asia makes up 30% of Citi’s business. That’s substantial.

    My argument is simple: Western Financial Centres serve more than just Western clients. Rather, they service the entire globe. Thus, as global commerce grew over the past 20 year at rates far exceeding western GDP, surly the size of the WFCs would be expected to increase as a percent of Western GDP.

  45. ** “In tangent with many others, it seems essential that we sooner or later aim for a population of no more than 5 billion and that our global wealth needs to be redistributed fairly among all inhabitants of our planet.” **

    In other words, let’s kill everyone and split the cash.

  46. Tertius Oculus,
    One’s intent is to raise the issue that over-population is having an adverse effect on our planet – global warming being just one example of this significant issue.
    There is a huge difference in managing population growth and what you are misrepresenting from my words.
    I think the key issue now is actually managing a net decline, something that is already occurring in much of the developed world – look at Japan for instance.
    Further, why invest money in trying to reduce infant mortality rates, hence increasing mouths to feed, and then not correspondingly increasing aid or opportunities for those very same individuals – you condemn them to a life of abject poverty.
    many persons speak of socialism as an answer, i think the word should be a more ‘equitable’ distribution of wealth.
    Until you address the fact that 1% of the global population owns the majority of the wealth, nothing will change.
    I note, the USA is incapable of providing comprehensive health care for its citizen, and yet its one of the richest countries globally.
    Could you please answer why this is the case?
    By ignoring the elephant in the room, we do ourselves a grave injustice.
    The present financial crisis has opened the door of debate on our presently flawed capitalistic economy and our duty, that is those that actually care, is to engage in this debate.
    Reforming the US financial services system is a start, sooner or later though, the fundamental issues I and many other serious minded individuals raise though will need addressing at a global level if we wish for our children and their offspring to inherit a planet worth living in.
    As I’ve stated previously, just look at Haiti, take this as a warning of what the world may look like in 50-100 years if our population exceeds its present levels and capitalism is left unchecked.

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